1. business and industrial
2. company
3. earnings

Competitors are welcome: why incumbents might
embrace entrants?
Barna Bak´o
∗
April 24, 2013
Abstract
In this article we show that the price and the profit of an incumbent
firm may increase after a new firm enters its market. Our analysis suggests
that a well-established firm after competition emerges on its market might
benefit from excluding some consumers from the low-end segment and
concentrate only on its loyal consumers.
JEL codes: D43, L11, M31
Keywords: product differentiation, consumer segmentation, marketing strategy
1
Introduction
Picture an industry where a monopolist operates initially and serves consumers
who differ in their quality valuation and price elasticity. Will an entry jeopardize
the incumbent’s profit or should the monopolist accommodate the entry? One of
the main proposition of economic theory is that competition leads to lower prices
and profits. In this article we present a simple model with product differentiation
where exactly the opposite happens.
We consider the following set-up: there are two segments of consumers differing in their valuation of quality and price-elasticity. A single product firm
operates at the market without being able to price discriminate among segments.
∗ ‘Lend¨
ulet‘ Strategic Interactions Research Group, Corvinus University of Budapest, Department of Microeconomics, F˝
ov´
am t´
er 8, E225-A, Budapest, 1093, Hungary, e-mail:
barna.bako@uni-corvinus.hu
1
Our results show that if a low quality firm enters the market and captures a part
of the price sensitive segment it might lead to price and profit increase. More
specifically, if the difference in quality valuation is high enough the incumbent is
better off after entry. Furthermore, we show that as the price-sensitive segment
decreases the equilibrium prices increase. Hence, the incumbent may benefit
from excluding some of its most price-sensitive consumers. Our main finding
suggests that a high-quality firm quits the low-end market entirely if the quality
valuation is high enough and the price-sensitive segment size is sufficiently low.
These results indicate that an entry can be beneficial for the incumbent firm.
This paper contributes to the literature on price-increasing competition. The
main body of this literature (e.g. Rosenthal (1985), Inderst (2002), Chen and
Riordan (2008)) concentrates mostly on price changes after competition picks
up. The literature closest to our article deals with the profit increasing effect
of the competition and the strategies an incumbent can pursue in order to
increase competition and its profit. Our first result echoes Gelman and Salop
(1983) findings. In their article they claim that an entrant can secure entry
accommodation by adopting a strategy of judo economics. This strategy refers
to a capacity choice sufficiently limited, which restricts the entrant!s market
share after entry. In this case, the incumbent choosing a higher price than the
entrant still can sell its product and under certain conditions be better off by
accommodating the entry. Their model, however, applies only if the entrant
can make credible capacity limitation commitments. As we show in this article
there is no need for capacity limitation to achieve this result.
A few other papers show findings similar to our results. By using a model
with a single manufacturer serving a market through a strategic retailer Kumar
and Ruan (2006) show that a manufacturer by complementing the retail channel
with an online channel effectively can induce retailers to enhance their support
level for the manufacturer‘s product which increases demand and consequently
its profit. Similar findings were presented by Ishibashi and Matsushima (2009),
who analyzed the competition between low-end and high-end firms. In both
quantity and price competition they show that if the low-end firms can capture
the whole elastic segment of consumers that could lead to higher profits for the
incumbents. In their model the existence of low-end firms functions as a credible
threat which induces high-end firms not to overproduce. In our model we show
that the existence of these kind of threats is not necessary for this result.
Alexandrov (2012) analyzes the question of de-marketing in a segmented
market and arrives to the conclusion that horizontally differentiated firms can
be better off by forbidding a group of consumers from patronizing the firm and
leaving that segment to be served by the other firm or a new entrant. However
quitting the low-end segment by all the firms does not constitute an equilibrium.
If a firm stops serving the price-sensitive consumer group, the firm‘s competitor
is much better off since she benefits from higher margins together with higher
volumes. Thus, firms opt for a unilateral quit by their competitor and might end
up serving all consumer segments which gives rise of the problem of coordination.
To solve this problem we introduce asymmetric firms and analyze the effects of
de-marketing in a more general model.
2
2
The Model
Consider a mass of consumers with a high-end (H) and a low-end (L) segment.
Each consumer group is uniformly distributed on the [0, 1] interval. The mass
of high-end market is normalized to 1 and the total number of consumers in the
low-end market is µ. In order to consume, each consumer has to travel to a manufacturer where the desired product can be purchased, and further we assume
that the transportation costs are quadratic in distance. The two groups differ
fundamentally in (a) their travel cost and (b) their valuation for the quality of
service they receive while shopping. The high-end segment has a transportation
cost of tH , and the low-end group of tL , and consistent with the above mentioned
tH > tL > 0. That is, the low-end consumer group is more price sensitive than
the high-end group. Furthermore, we assume that consumers from the highend group value the service as sH while the price-sensitive group as sL , where
sH > sL . Consumers in H demand only a product with complementary service,
while consumers from the low-end group are indifferent between a product with
or without service. Both consumer group has a reservation utility of v for the
product and each consumer demands, at most, one unit. We assume that v is
high enough to ensure that all consumers buy one product in equilibrium.1 To
simplify our calculation we normalize the value of tH to 1 and set sL to zero.
Furthermore, we assume that sH − sL > tH − tL , that is consumers are more
differentiated in the way they value the services as they are in travel costs.
2.1
The monopoly case
Suppose, there is a single firm located at 0 producing a product and selling it
by providing a complementary service to it without being able to price discriminate between the consumers. Furthermore, we assume that the monopolist is
obligated to cover the whole market2 . The production marginal cost is c > 0,
while the fixed costs are zero.
A consumer of group j (j = L, H) located at x obtains a surplus from buying
the manufacturer‘s product as follows
CSj = v + sj − tj x2 − p
(1)
Thus, in order to maximize its profit a monopolist sets a price of
pM = v − tL
(2)
π M = (1 + µ)(v − tL − c)
(3)
and its profit is
1 In
the subsequent analysis we give the exact lower bound of such a v.
service obligations or USOs are not uncommon in monopoly regulation. Their
use is especially widespread in the area of postal services, utilities and telecommunications.
For a detailed discussion on definitions of universal service, see Alleman et al. (2010)
2 Universal
3
2.2
The duopoly case
Now consider that a low-quality firm, l, with no marginal cost enters to the
market and offers a product without any additional service. In the further
analysis we refer to the product without any complementary service as lowquality product, and to the incumbent‘s product as high-quality product3 . We
consider the polar case of quality differentiation and without loss of generality
we assume that the firm l is located at 1, while the incumbent firm (from now
on denoted as firm h) is located at 0.4
Since consumers in H demand only the product with an additional service
they keep purchasing the product from firm h., and the surplus of a consumer
located at x obtained from consumption is
CSH =
v + sH − x2 − ph
0
if she buys from firm h
if she buys from firm l
(4)
where ph is the price of the product with complementary service.
Consumers in L value both products similarly, and for that reason they are
indifferent which product to consume as far as their price is equal. Denoting
the price of the low-quality product by pl , the utility of a consumer in L at x
can be given as
CSL =
v − tL x2 − ph
v − tL (1 − x)2 − pl
if she buys from firm h
if she buys from firm l
(5)
Consumers purchase the product which yields them to the highest surplus.
Thus, the consumer i from the low-end market located at x buys from firm h if
l
, otherwise she buys from firm l. Hence, the demand functions
xi ≤ 21 − ph2t−p
L
of the firms are as follows
1 ph − pl
DH (ph , pl ) = 1 + µ
−
(6)
2
2tL
and
1 ph − pl
−
DL (ph , pl ) = µ 1 −
2
2tL
Using (6) and (7) the profit functions of the firms can be given as
1 ph − pl
πh = 1 + µ
−
(ph − c)
2
2tL
(7)
(8)
3 We do not make here any assumption about market coverage; in practice, oligopolies do
not face as strict regulation as monopolies. However, our result will show that even absent
regulation, the firms will provide full market coverage.
4 This assumption based on d’Aspremont et al. (1979). The authors show that in location
games with quadratic transportation costs the equilibrium locations are the two extremes.
4
1 ph − pl
πl = µ
+
pl
2
2tL
(9)
Solving the first-order conditions, leads to
Proposition 1 In equilibrium firms charge
1
4tL
1
2tL
D
D
ph =
3tL + 2c +
and
pl =
3tL + c +
.
3
µ
3
µ
These are equilibrium prices only if the market is fully covered. For that we
need the surplus of the consumer from group H located at 1 to be non-negative
with the given prices. By evaluating this we set the lower bound of v consistent
with the model. Thus, we need, that
v + sH − 1 −
4tL
1
3tL + 2c +
≥0
3
µ
(10)
Simplifying (10) yields
4 tL
2
− sH
v ≥ v ≡ 1 + tL + c +
3
3 µ
(11)
That is, if (11) is satisfied, the market is fully covered in equilibrium and prices
given by Proposition 1 are indeed the equilibrium prices.
Corollary 1 More differentiation results in higher equilibrium prices.
Proof.
∂pD
j
>0
∂tL
for every j = h, l.
Corollary 2 If the price sensitive segment is increasing the equilibrium prices
are decreasing.
Proof.
∂pD
j
<0
∂µ
for every j = h, l.
The intuition behind these corollaries is that as the differentiation between
products increases the substitution is becoming more difficult which softens the
5
competition in the market. This gives the firms the incentives and the possibilities to increase their prices. However, as the more elastic group is becoming
more dominant relative to the less price sensitive segment the equilibrium prices
drop.
Substituting the equilibrium prices into the profit functions given by (8)
yields to
Proposition 2 In equilibrium firms profits are
πhD =
2
4tL
µ
3tL − c +
18tL
µ
πlD =
and
2
µ
2tL
3tL + s − c +
18tL
µ
Using the result obtained so far we can evaluate the conditions under which
an incumbent is better off by having a low-quality competitor than serving the
consumers from each segment by itself. For this we need
2
µ
4tL
(1 + µ)(v − tL − c) <
3tL − c +
18tL
µ
(12)
that is
v<v
D
2
4tL
µ
3tL − c +
+ tL + c
≡
18tL (1 + µ)
µ
(13)
If v ∈ (v, v D ) the incumbent profit increases if a low-quality firm enters the
market. Although, for this v D has to be higher than the lower bound of the
reservation prices (v), hence, we have to check if
2
2
4 tL
µ
4tL
1 + tL + c +
− sH <
3tL − c +
+ tL + c
3
3 µ
18tL (1 + µ)
µ
(14)
Rearranging (14), yields to
sH >
sD
H
2
4 tL
µ
1
4
≡1+ c+
+
tL 3 +
−c
3
3 µ
18tL (1 + µ)
µ
(15)
Proposition 3 If the differentiation in quality valuation is high enough a highquality firm is better off if a low-quality firm enters to the market than covering
the market as a monopolist.
This above proposition suggests that a firm can be worse off by being a
monopolist than allowing a low-end firm to enter the market. As the entrant
enters the market and captures the price-sensitive consumers the incumbent
serves mostly its most loyal consumers. Since these consumers have significantly higher reservation utility the incumbent can rise its price which offsets
the demand loss. In other words, losing the price-sensitive consumers because
of the competition in the low-end segment gives the incumbent the opportunity
6
to set a higher price for the loyal consumers who exhibit a substantially higher
reservation utility.
To show that equilibrium prices in the duopoly case are higher than the
monopoly price, we need
1
4tL
1
2tL
3tL + 2c +
> v − tL
and
3tL + c +
> v − tL . (16)
3
µ
3
µ
2
From the left-hand side inequality in (16) we have that v < 2tL 1 + 3µ
+ 23 c.
This needs to be higher than the lower bound of the reservation utilities, which
holds whenever sH > 1 − 3tL . In the same way we can calculate the condition
when the equilibrium price of the low-end firm is higher than the incumbent
monopoly price. This yields that sH > 1 − 3tL + 13 c. The result is formulated
in the following
Proposition 4 If consumer differentiation in service valuation is significant,
equilibrium prices charged by a low-end and a high-end firm are higher than the
prices charged by a monopolist who covers the market fully.
3
Strategic demarketing
In fact, under certain conditions the incumbent firm has the incentive to deviate
from the equilibrium given in Proposition 1. To illustrate this consider the
following.
From (2) follows
Corollary 3 The high-quality firm benefits from excluding some consumer of
the most price sensitive segment if the size of this segment is less than moderate.
Proof.
2 1
4tL
∂πhD
=
(3tL − c)2 −
∂µ
18tL
µ
This is negative whenever µ < µS ≡
4tL
3tL −c .
Corollary 3 suggests that the high-quality producer might be better off by
quitting the more elastic segment. In this case prices and profits can be easily
calculated, since in both segments only a specific firm operates and therefore it
will charge a price which binds consumers reservation utility.
Formally, the firms profits can be given as follows
πh = (ph − c)DH (ph )
and
πl = pl DL (pl )
(17)
where DH (ph ) and DL (pl ) stands for the demands faced by firm h and l, respectively. Since consumer‘s reservation utilities are high enough to provide
7
non-negative surplus even for the consumer farthest away from the company she
buys from, in equilibrium firms charge prices that consumers with the biggest
distance from the company can still afford. Formally, we can state the following
Proposition 5 Suppose firm h quits the low-end segment. Equilibrium prices
and profits are as follows:
pSh = v + sH − 1
pSl = v − tL
and
πhS = v + sH − 1 − c
πlS = µ(v − tL )
Comparing the results given in Proposition 2 and 5 we can determine conditions under which strategic demarketing is indeed an equilibrium. For this we
need
2
4tL
µ
< v + sH − 1 − c
(18)
3tL − c +
18tL
µ
A different way to write this is
2
µ
4tL
sH > sSH ≡
−v+1+c
3tL − c +
18tL
µ
(19)
Hence, we have the following result
Proposition 6 The high-quality firm stops serving the low-end segment if the
consumers differ fundamentally in their complementary service valuation and if
the more price-sensitive segment size is sufficiently low.
The intuition behind Proposition 6 is the following. To serve any of the
consumers from L firm h has to lower its price below the reservation utility of
the least valuable consumer from H. The price decrease is more significant if the
service provided by the firm is more valuable to the consumers. Hence, there is a
significant consumer surplus what the high-end consumers obtain because of the
low prices. By quitting the low-end segment, firm h is not facing any competition
from the low-quality firm and therefore can set its price higher. However, if the
low-segment is remarkable is size quitting the price-sensitive group can hurt the
firm‘s profit, since the price increase cannot offset the loss caused by the major
demand loss. Actually, the same happens when consumers reservation utility
is high enough. Softening the competition by leaving a segment and operating
only on one segment, drives prices higher. As the demand loss is not significant,
the profit rises as well.
Notice that when strategic de-marketing is profitable it always leads to higher
average prices as well. This is because the low-end prices are unchanged after
a low-quality firm enters the market and the high-end consumers pay more for
their products..
8
4
Conclusion
We summarize our results in the following table. As you can see from the table
the incumbent monopolist is better off by accommodating a low-quality entrant,
if its quality is valued highly by a group of consumers. Allowing the low-end firm
µ < µS
µS < µ
sH < sD
H
S
sD
H < sH < sH
π M > max{πhD , πhS }
π M > max{πhD , πhS }
πhD > max{π M , πhS }
πhD > max{π M , πhS }
sSH < sH
πhS > πhD > π M
> max{π M , πhS }
πhD
to capture the low-end market gives the incumbent the possibility to increase its
price aggressively which offsets the loss from demand decrease. Moreover, if the
price sensitive segment is not significant in size the manufacturer is even better
of by quitting the low-end market entirely. To achieve this goal the incumbent
could (1) forbid the price-sensitive consumers to purchase its product, (2) pursue
a negative de-marketing campaign or (3) launch a low quality product by itself
and segment its consumers effectively. Our results suggest that competition can
be beneficial for the incumbents. In other words, established firms should not
necessarily get involved in price competition after a new entrant enters their
market but rather focus on (de-)marketing strategies.
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9
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10